cheap ray bans is an impact that an investor will have to judge relative to their overall portfolio. I personally believe it is distorting the pricing of risk since about mid last year

Chesapeake Granite Wash Trust NYSE

Last quarter for Chesapeake Granite Wash Trust (NYSE:CHKR) was interesting because it provided a range of areas that showed change, mostly in a positive direction. But it was still an ugly quarter, so I will get that part of the report out of the way first.

On May 9, CHKR announced its quarterly distribution for production during the time period December 2012 through February 2013. CHKR is heavily weighted in production to natural gas so favorable trends in natural gas prices would lead one to expect a decent quarter for the Trust given the low levels gas prices reached over the past year. However, CHKR’s distribution of $0.69 was 20% below target, and was so poor that the earnings on a fully dilutive basis could not cover the subordination threshold for the Trust. On a fully diluted basis the distribution was $.59, which was 32% below target so the subordinated units of the Trust (all held by Chesapeake) received a distribution that was substantially lower.

The lower distribution level is not a surprise, because it has become the new normal for the Trust. As the above graph shows, the distribution levels have been below the IPO target for the past five quarters. The rise since August 2012 is not a function of better performance it is only a function of the subordination threshold, which is 80% of target. On a fully diluted basis, the past four quarter distributions have been the subordination threshold amount.

The Trust press release references lower total sales volume and realized price levels as the cause for the miss. The market share price leading up to the announcement was positive, and there was no reaction to the announcement which likely means that the actual results were not a surprise, and there are other factors that are specific to the Trust as well as general market trends that are currently positive for share demand. The overall market rally, to the extent it is caused by Federal Reserve policy, is an impact that an investor will have to judge relative to their overall portfolio. I personally believe it is distorting the pricing of risk since about mid last year, and have written on the topic. But at the moment, this type of distortion is not likely to break if investors are waiting for it. The best strategy at this stage is not to overpay for risk and "hope" for any individual holding in your portfolio.

The specific areas that I see affecting the expectations for future Trust performance are what I will focus on in this article.

Review of Recent Market Impacting EventsIn the article I published before the opening trade on March 20, "Chesapeake Granite Wash Trust Updated Reserves Show Major Downward Revision, Buyers Beware," I analyzed the Trust’s proven reserve revisions as announced in the published Dec. 31, 2012, 10 K. The day this article was published the information was not yet priced into the shares, and the shares fell from over $17 to slightly below $14 in two trading days. This over $3 gap down in share price provides a good indication of the market expectations of how big a negative impact the reserve revision would have on the future value of the Trust.

Since that time, the shares traded sideways until mid April, and then began a 20% retracement back to the level it was just before the information about the revision to Trust reserves became public. A part of this rally is correlated with the S which is up 8% over the same period. But the out performance needs some additional explanation. There are some positive signals regarding the initial revision. The Trust CEO announced on May 9 that by drilling only three wells per AMI section instead of four, well performance loss on wells yet to be drilled is possibly mitigated. This means that at least on the remaining wells the issue may not be as bad as expected. So, maybe there is a rational for hope, at least on the remaining undrilled wells, and is in my assessment the likely reason shares have recovered since mid April.

So, how do you evaluate all of these moving parts and assess the current share price? This report will provide information to fairly assess the situation for yourself and provide my assessment of the value of the Trust at this time.

CHKR Earnings Performance AnalysisIn the press release announcing the Trust results, management pointed to "lower sales volume and realized prices" than the estimate in the IPO Target as the reason that the distribution target was missed. This was not unexpected given the PV 10, which showed a sharp decrease in MBOE proven reserves of 26.6% during 2012 due to well performance. During the quarter volume was 942 MBOE, down 7.6% from a high of 1020 MBOE in the spring production period in 2012 (current quarter distribution is for prior quarter production), and also 4.3% lower than the 984 MBOE registered one year ago.

The earnings for the most recent quarter, however, did not track lower with production which is a relative good sign. My review of the results show that realized prices in general were positive for results. Any statements about realized prices are only indicating that the price level was not as good as it could have been, primarily due to the continued low NGL price and the wide differential spread to oil. But overall, the earnings line is restrained largely by lower production, which to the extent it is not caused by decisions to hold product off the market, is a result of lower well performance, which is not recoverable in the future.

Drilling ProgressIn the graphic below you can see that drilling has been accelerated by Chesapeake (NYSE:CHK) ahead of the IPO schedule. The Trust drilling is expected to be completed by the end of 2014.

Drilling completion in December 2014 or early 2015 means that subordination will likely end starting with the August distribution in 2016. The IPO prospectus projected that the end of subordination could take as long as the June 2017 quarter. The biggest news with respect to drilling during the quarter was the remedy Chesapeake is using to mitigate the well performance issue on future drilled wells with respect to the problem encountered with drilled wells that have gone into production, and wells conveyed to the Trust. The statement about the well performance issue during the earnings call was as follows:

The changes to previous estimates were primarily as a result of higher than expected pressure depletion within certain areas of the Granite Wash AMI. To mitigate this issue we are evaluating the benefits of drilling only three wells per section rather than four wells. Preliminary results while early have been encouraging.

The Trust has 45% of the total wells that Chesapeake is responsible to drill still remaining to be drilled. The undrilled wells represent 28% of the total wells the Trust expects to have in production at the end of drilling.

10 Q Statement about the ImpairmentHere is an excerpt found in the accounting notes from the 10 Q published by the Trust on May 8, 2013:

Impairment of Royalty Interest. During the quarter ended March 31, 2013, the Trust recognized a $32.9 million impairment of the Royalty Interest. The impairment was the result of reserve revisions that were due to current results being below expectations, primarily as a result of higher than expected pressure depletion within certain areas of the AMI. This has resulted in lower initial production rates and lower expected ultimate recovery in certain recent development wells.

A couple of analytical notes for investors:

The $32.9M write off in book value of the Trust Investment is lower than the PV 10 downward adjustment on a relative basis. 31, 2012, PV 10 reduced the proven reserves by 11,756 MBOE on a conveyance of 44,266 MBOE or 26.3%, netted to 22.8% if you add discoveries and extensions in 2011. On a relative basis, one would expect that the write off of the Trust Investment would need to be of similar magnitude. Based on existing public information it is hard to know whether the mitigation plan is just to make sure the major reserve revision in the PV 10 does not get worse, or whether there can be some recovery from the initial estimate. This question was not directly asked at the earnings call. I am inclined to want some actual evidence of improvement before bidding up the shares based on the accounting entry. However, there is a probability the results won’t be as bad going forward. I will provide information about how this can (and already has) affected share value in the fair value section of this article.

Production Mix AnalysisThe PV 10 published in the most recent CHKR 10 K showed that the Trust over the past year showed a slight decline in oil in its production mix relative to natural gas and NGL. This product mix composition trend continued to be confirmed in the past quarter results:

The trend over time has had a small impact on the value of the Trust as BOE volume has trended to lower value products. However, the impact in the most recent quarter due to production mix was not a major contributing factor on earnings performance.

The biggest positive impact on the CHKR Trust earnings performance in the past quarter can be found in the market price for natural gas. In the graph below you can see the actual market prices for oil, gas and NGL during the past year and the last production period.

The average realized price at the Trust was $31.74 in the November to February production quarter. This is 6.23% higher than the $29.76 the prior quarter. As the market prices reflect, the big downward change in the realized price level at the Trust occurred three quarters ago when both oil and NGL prices suffered significant declines.

Overall the improvement in realized price is primarily due to the increase in natural gas prices. The Trust oil production is estimated to be 100% hedged with derivative contracts that lock the realized price at $88 per barrel for oil. The NGL price is hedged using oil to the extent swap contracts cover production volume at a ratio of approximately 2 to 1. This only hedges general energy market price declines and does nothing for swings in the underlying NGL product market. As you can see from the graph, NGL market prices have been in the dumps since last summer and remained low during the past production quarter. The spread differential of 2.6:1 over the past several quarters has placed a strain on realized NGL prices when the impacts of the hedges are included.

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